Borrowing From a 401(k)

Q:
I have started researching and following individual stocks, and I now feel I have strong instincts that the stocks I choose will do well. My largest potential source of funds is my 401(k) plan savings. I'm thinking about borrowing from my 401(k) to invest. My hope is that I make a decent profit and pay back the loan. Is this a smart or stupid move? -- L.M., via the Internet

A: We Fools like to say that any money you invest into the stock market should be money that you aren't going to need for at least five years. Will your 401(k) plan allow you not to pay back the loan for five years? Not if it's like any of the ones we've heard of. And for that reason, while we wouldn't necessarily call your strategy smart or stupid, we would call it very unFoolish.

Although a bear market might be considered a 401(k) investor's best friend (more on that in a moment), it would be perilous for anyone who must start paying back a loan, with interest, within a short time frame. No matter how much you like a company, you should dedicate money to it only with the understanding that the share price could decline steeply within a short time period and stay there, and that the best way to protect yourself from being hurt by that is to make the time you're planning to be in the market as long as possible.

Consider the advantages of not borrowing any money from your 401(k) when the market goes down. If you are contributing regular amounts, say $200 every two weeks, when the market goes down, you're actually getting more than you were before a market plunge. (The same investment divided by lower market prices makes for more shares acquired.) A 401(k) investor in her 20s, 30s or 40s should consider it this way -- the market is going to be wherever it is going to be 20 or 30 years from now when you retire. The longer it stays comparatively low, or the more it goes down, the more you can acquire with every biweekly 401(k) contribution.

The person who borrows from a 401(k) is betting on just the opposite happening. He or she is betting on the market (or some individual stocks within the market) going up, a lot, and very soon. But that introduces a level of market-timing into the equation that the Foolish investor will always choose to avoid. Also, if you've borrowed money from a 401(k) plan and your employment ends, either by your choice or your employer's, you would have to pay back the loan immediately -- so consider that as well.

WHAT NOW? Is a bear market coming? No one knows, but Warren Buffett, the world's most famous investor, thinks that the next 17 years won't offer a market moving up as fast as the last 17 did. Click herefor his thoughts.
For more on managing your 401(k), click here.